With the Securities Exchange Commission (“SEC”) at an impasse, the Financial Stability Oversight Council (“FSOC”) has the authority to regulate money market funds (“MMFs”) as systemically significant nonbank institutions. Why should they do this? Because MMFs provide trillions of dollars in short term funding to the financial industry and much of corporate America. If those funds are withdrawn from the financial system rapidly, as they were during the last crisis, significant parts of the financial system and the economy seize up and begin to fail.
When people start to worry about their money, they withdraw it, often in very large numbers and at the same time. During the last crisis, that’s what happened with MMFs, which were referred to as the canary in the coal mind because that is where people withdraw their money the quickest and earliest. To prevent that “run” on MMFs (really no different than the bank runs of old), the government, meaning U.S. taxpayers, effectively guaranteed the entire $3.7 trillion industry (initially directly and subsequently indirectly with an insurance program). That $3.7 trillion program was the single largest rescue/bailout program during the last financial crisis.
Since then, many different ideas have been proposed to prevent U.S. taxpayers from being on the hook again and having to bailout the MMFs from losing their investors during the next crisis. MMFs are regulated by the SEC and it has been at the center of these discussions. However, yesterday the Chairman couldn’t get three votes to propose a rule to address the systemic issues raised by MMFs.
FSOC is charged with protecting the overall financial system, identifying current and emerging systemic risks, and acting to reduce or eliminate them. It has the authority to do this directly and as a backup to a primary regulator that fails to do it in the first instance. Thus, FSOC can regulate MMFs in one of two ways:
First, FSOC has broad authority under the Dodd Frank Act (“DFA”) to impose new or heightened standards on MMFs:
FSOC can direct the SEC to impose new or heightened standards and safeguards to MMFs
- Section 120 of the DFA gives FSOC authority to “provide for more stringent regulation of regulated financial activities by issuing recommendations to the primary financial regulatory agencies to apply new or heightened standards and safeguards, including standards enumerated in section 115, for a financial activity or practice conducted by bank holding companies or nonbank financial holding companies under their respective jurisdictions, if the Council determines that the conduct, scope, nature size, scale, concentration, or interconnections of such activity or practice could create or increase the risk of significant liquidity, credit or other problems spreading among bank holding companies and nonbank financial companies, financial markets of the United States, or low-income, minority or underserved communities.” (DFA section 120(a); emphasis added)
- Given what happened in the last crisis, there is no genuine dispute that MMFs “could create or increase the risk of significant liquidity, credit or other problems spreading among bank holding companies and nonbank financial companies, financial markets of the United States….”
- As described in Section 115 of the DFA, FSOC-recommended prudential standards can include risk-based capital requirements, leverage limits, liquidity requirements, concentration limits, and other requirements.
- Thus, FSOC has the authority and power to direct the SEC to take systemic risk-mitigating actions regarding MMFs.
- Interestingly, the DFA does not include specific FSOC voting rules for Section 120. So it would appear that FSOC could determine to recommend higher standards by majority vote or another standard (provided that it wasn’t arbitrary and capricious).
- However, FSOC can only make “recommendations” and the SEC could decline to adopt them. (DFA section 120(c)(2)) While that may be unwise (given that it would have to reject FSOC’s recommendations which would be based on FSOC’s determination of system risk), the Chairperson might still be unable to get the votes to adopt a rule implementing FSOC’s recommendations.
Second, the DFA provided FSOC with a another method of responding to systemic risks if a primary regulator fails to implement its recommendations (or otherwise for that matter).
- FSOC can directly designate MMFs for supervision and regulation by the Federal Reserve
- Under Section 113 of the DFA, if FSOC determines by a 2/3 vote of its 10 voting members, including an affirmative vote of the Treasury Secretary, that “material financial distress at the U.S. nonbank financial company, or the nature, scope, size scale, concentration, interconnectedness, or mix of activities of the U.S. nonbank financial company, could pose a threat to the financial stability of the United States”, then the company will be designated for supervision by the Federal Reserve and subject to prudential standards recommended by FSOC under Section 115 of the DFA. (DFA section 113(a)(1); emphasis added)
- There is no genuine dispute that MMFs “could pose a threat to the financial stability of the United States,” as proved in the last crisis and by the need for a $3.7 trillion program to stop a run on the MMFs and the contagion that would have followed throughout the entire financial system
- This statutory authority is broad enough to allow FSOC to designate classes of firms, such as MMFs, for new or heightened standards and safeguards. (See, Better Markets FSOC comment letter on designation of systemically significant nonbank firms, pp yy zz)
- As described in Section 115 of the DFA, prudential standards can include risk-based capital requirements, leverage limits, liquidity requirements, concentration limits, and other requirements. (DFA section 115(b)(1))
There is also a third potential way for FSOC to regulate MMFs. In October, 2011, FSOC issued a Notice of Proposed Rulemaking (NPR) implementing Section 113 of the DFA. The proposed rule set out procedures for FSOC to identify, designate and regulate systemically significant nonbank firms. However, that rule has not yet been finalized. Nevertheless, anticipating that MMFs or other types of funds managed by asset management firms might be systemically significant, the proposed rule had a special provision for asset managers that authorized FSOC to take action if needed.
- Under the procedures in the proposed rule only nonbank firms with assets greater than $50 billion would be considered for designation with one exception: the NPR recognized that this asset cut-off might not adequately address the stability issued posed by asset-management firms. The proposed rule, therefore, explicitly noted that the $50 billion threshold or other criteria might not be applied to asset managers:
- “In addition, [FSOC], its member agencies and the OFR will analyze the extent to which there are potential threats to U.S. financial stability arising from asset management companies. This analysis will consider what threats exist, if any, and whether such threats can be mitigated by subjecting such companies to Board of Governors supervision and prudential standards, or whether they are better addressed through other regulatory measures. The Council may issue additional guidance for public comment regarding potential additional metrics and thresholds relevant to asset manager determinations.” (Federal Register, Volume 76, Number 201, October 18, 2011, 64269.)
- Thus, if the proposed rule were to be finalized, FSOC could still impose prudential standards on MMFs after it
- “analyze[d] the extent to which there are potential threats to U.S. financial stability arising from asset management companies;”
- “consider[ed] what threats exist, if any;” and
- “whether such threats can be mitigated by subjecting such [MMFs] to Board of Governors supervision and prudential standards, or whether they are better addressed through other regulatory measures.”
In our view, this three step process for MMFs (or asset managers more broadly) should not be necessary because all those determinations were in fact made as recently as 2008 when the systemic risk of MMFs materialized, causing the U.S. government to implemented emergency rescue measures to protect the $3.7 trillion industry, the larger financial system and the stability of the U.S.
In fact, in our comment letter on the proposed rule, we recommended that any firm, entity or activity that received any type of extraordinary aid, bailout or rescue measure in the last crisis be presumptively identified for consideration for designation as systemically significant. Given that they in fact received aid, assistance or a bailout in the most recent crisis – which they only received because they were determined to be systemically significant literally in the middle of a financial crisis – this did not seem to us to be a controversial suggestion. This is true particularly because any such firm, entity or activity so identified would still go through the multi-step process to determine whether or not it was in fact systemically significant and, therefore, to be designated as such.
There is no way to tell if FSOC intends to adopt this suggestion. However, given what is now happening regarding MMFs, we would again urge that FSOC adopt it, because it would put MMFs immediately under review and make it far easier to reduce the threat they pose to systemic stability.